MercadoLibre: Knock Knock, You Are Not Alone Jeff!

The most attractive opportunity in the market with giant, giant MOAT and attractive valuation!

Among all the great entrepreneurs of the last century, I admire two above all: Steve Jobs and Jeff Bezos.

Jobs was the most remarkable entrepreneur of the last century:

• He didn’t finish college.

• He wasn’t a nerdy engineer.

• He didn’t raise millions in VC.

Yet, he created the most valuable company in the world.

How? Two things: He had a great taste and he understood the value of ecosystems.

While everybody else was creating open systems, Jobs insisted on creating closed ecosystems.

He initially made the iPod only compatible with Macs and theorized that iPod sales would also boost Mac sales.

He was right. In 2002, Apple sold 3.1 million Macs. This reached 7 million in 2007.

In 2007, iPhone came out, Mac sales again doubled in the next 3 years, reaching 14 million in 2010.

In Apple’s case, creating an ecosystem required closing products to third parties and Jobs did that.

In late 1990s, when Steve Jobs regained the control of Apple and started creating its closed ecosystem, Jeff Bezos also made a critical decision to create Amazon's ecosystem: Opening up its platform to competitors.

In Amazon’s case creating the ecosystem required opening up the platform, unlike Apple.

Bezos understood this as he realized the immense inefficiency associated with selling stuff directly. He knew the model could never be immensely profitable:

• Inventory management was costly.

• Operation was slow.

• Scale was limited.

He realized that opening up the Amazon platform to other merchants that didn’t have distribution in exchange of commissions would be much more profitable and scalable.

So he did this, Amazon marketplace was launched in late 2000.

Merchants flocked to the platform.

Nowadays, the core services of Amazon’s marketplace are:

• Storage and fulfillment.

• Smooth payment processing.

• Customer acquisition through ads.

It’s a great ecosystem composed of a core product (marketplace) and value adding complementaries (fulfillment, payments, customer acquisition).

This wasn't luck, it was a genius business strategy.

MercadoLibre has successfully followed the ecosystem playbook.

It integrated complementary services and created an ecosystem comparable to that of Amazon:

Jeff Bezos wrote the playbook, and people followed. Most of them failed as it’s exceptionally hard to execute, but Meli succeeded. Jeff isn’t alone in the room of achievers.

MercadoLibre was founded in 1999 but its story is just starting.

60% of the Latin American population is still underbanked, most of them never had credit cards to use in online shopping. Infrastructure is still decades behind the United States and the political environment has always been volatile.

In these conditions, Meli took longer to execute so in relative age it’s a much younger company than Amazon and it’s a huge runway to grow:

• LatAm population is growing faster than other regions.

• Millions of people will come out of poverty in the next decade.

• Neobanks are facilitating use of online services like online shopping.

In this environment, MercadoLibre, a company that holds the largest e-commerce and the fintech platform in the region has an opportunity to become a giant, and I mean truly giant.

So, if you are intrigued enough, let’s cut the BS here and dive deep into this great company!

What are you going to read:

1. Understanding The Business

2. Moat Analysis

3. Investment Thesis

4. Fundamental Analysis

5. Valuation

6. Conclusion

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🔑🔑 Key Takeaways

🎯 Mercadolibre is successfully following the Jeff Bezos Playbook. It benefits from direct and indirect network effects driving exponential growth.

🎯 On top of its marketplace, it created an ecosystem of complementary businesses, effectively locking in users and merchants. Its moat is impenetrable.

🎯 LatAm e-commerce market is growing faster compared to peers as the population increasingly adapts to online services.

🎯 Its financial position is strong. Though it uses more debt than equity, its EBITDA can easily pay all the debt within three years.

🎯 The valuation remains attractive as the strong revenue growth will be maintained in the next decade by entry and expansion in LatAm countries where it’s not currently operating.

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🏭Understanding the Business

MercadoLibre is a giant digital ecosystem.

This is already rare but what’s even rarer is how it deliberately built this ecosystem by understanding distribution and consumer lock-in.

Ecosystems are built around a core product that provides distribution.

If you are in a B2B business, like enterprise software, where you generate high amounts of revenue from each user, distribution is not the foremost priority.

However, if you are in a consumer market, you need two critical things to succeed:

• Critical mass.

• Consumer lock-in.

Critical mass precedes consumer lock-in. Smart companies see that if you are in a consumer business, you are in a distribution business.

Take a look at the Apple ecosystem as an example:

Apple’s IOS platform is the distribution for its other products, accessories, software, applications, services etc…

Apple now has 1.5 billion active iPhone devices around the world.

If it develops a new AI application, boom, it will reach 1.5 billion iPhone users around the world in minutes.

Distribution first, complementary products later. This is the winning formula in digital B2C markets.

MercadoLibre understood this very well.

They built and scaled their e-commerce marketplace first. Just like Amazon marketplace you can find millions of items sold by thousands of merchants.

Once it realized that it had the distribution, it built and scaled complementary businesses around this distribution.

Together with its e-commerce marketplace, it now is an ecosystem of 6 integrated businesses:

• Marketplace: Its flagship platform and the core ecosystem product. It has more than 220 million unique active users. It also has an integrated ads service comparable to Amazon PPC ads.

• Mercado Pago: Fintech platform that offers digital payment solutions on and off MercadoLibre marketplace. Merchants can also integrate it into their own online stores to process payments, using it as a Stripe or a PayPal like service. It also offers physical point of sales devices to merchants, which is a service similar to what Square provides in the United States.

• Mercado Credito: Built on Mercado Pago, offers personal loans to both merchants and users. It uses the proprietary data MercadoLibre accumulated about the users over time to respond their liquidity needs. Such use of proprietary data significantly reduces default risks.

• Mercado Classifieds: It’s an online listing marketplace that allows users to list and purchase motor vehicles, real estate and services etc… It functions as a significant driver of traffic to other MercadoLibre platforms.

• Mercado Shops: Online storefront service comparable to that of Shopify. It also integrates storage and fulfillment services offered by Mercado Envios.

• Mercado Envios: MercadoLibre’s storage and fulfillment service that is similar to Amazon FBA. It has over 20 distribution centers in Latin America, and recently opened one in the US. What’s better? It has its own airplane fleet that helps them to improve delivery times.

Having the ecosystem is already great but what’s even more striking to me is its understanding of the ecosystem.

Throughout Meli's annual reports and investor presentations, you can find numerous references to “controlling consumer experience”. Here are some examples from the latest annual report:

The logistics services we offer are an integral part of our value proposition, as they reduce friction between buyers and sellers, and allow us to have greater control over the full user experience.

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The Meli Places network allows buyers and sellers to pick-up, drop-off or return packages with a better experience, reducing the travel distance for all parties.

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To complement the MercadoLibre Marketplace and enhance the user experience for our buyers and sellers, we developed Mercado Pago, an integrated digital payments solution.

This is not a coincidence and this understanding impresses me the most about MercadoLibre.

The reason is simple: Steve Jobs wanted an ecosystem to control the customer experience in the first place. He didn’t think that the closed ecosystems were superior to the open ones in terms of architecture but he thought that a closed ecosystem was a must to control the consumer experience.

Meli also understood that the ecosystem's main purpose is enhancing the customer experience. If your ecosystem doesn’t do that, you just have a compilation of services. It’s a conglomerate, not an ecosystem and the complementary services you offer are way more vulnerable against competition.

Once the complementary services are seamlessly linked to each other and enhance the customer experience, you have an ecosystem.

That’s when the much coveted consumer lock-in comes into effect.

Meli’s emphasis on controlling consumer experience shows that it understands this and this is what’s actually great.

If you have made it here, you now understand what Meli actually is.

It’s not an e-commerce company, it’s a giant digital ecosystem and we have to treat it that way to understand the real value of the business.

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🏰Moat Analysis

Oh God! I am thrilled to write this part. When I went through Meli’s business model and its services, I got a dopamine hit multiple times!

Meli is untouchable by competition. Plain and simple.

It starts with its marketplace, the core platform of its ecosystem.

There are two types of network effects:

• Direct network effects.

• Indirect network effects.

Direct network effects happen when the platform becomes more valuable to users as the number of users increases.

Social media platform created just for users and includes no advertisers is a good example. As the number of people using the platform increases, more people will be attracted to the platform as they will find many of their friends on the platform.

Indirect network effects happen when there are two sides to the platform. Think about Instagram. There are users and there are advertisers. As the number of users increases, it becomes more valuable for advertisers.

Having one of them is already a really effective competitive advantage; having both of them is a holy grail.

MercadoLibre Marketplace has both of them!

Increasing number of buyers on the platform attracts more sellers. This enriches the catalog and leads to lower prices due to competition among sellers. Lower prices and large catalog attract more buyers, creating very strong indirect network effects.

More buyers also singlehandedly makes the platform more valuable for other buyers as it causes expansion of scale. As the merchants scale, their costs decline and they pass some of their cost savings to the buyers. This shared economies of scale makes the platform more valuable for buyers.

Now, let’s place the entire Meli ecosystem on top of this structure piece by piece and see how each piece strengthens its moat.

Let’s start with the fulfillment.

It works just like Amazon FBA.

Now think that you are a Latin American merchant who would really struggle managing all those operations if it wasn’t for Meli Envios.

It makes it so easy for merchants to manage inventory and logistics that they become even more loyal to the platform. If they leave the platform, they will have to deal with all those operations themselves.

Now look from the perspective of buyers: You can get 2 days shipping in millions of items. You wanted something and Googled it. You found two stores: One is a private online store the other one is a Meli store that offers 2 days shipping. Which one would you pick? Exactly.

Additional reason for consumer and merchant loyalty.

Now, think about Mercado Pago.

This is indeed revolutionary.

Imagine you are operating both a physical store and online store on Meli. You use Mercado Pago point of sales devices in your physical store.

You can seamlessly process payments on both sides and when you look at your Mercado Pago account you’ll see the consolidated results for your business.

On top of that, add the fact that 70% of Latin American population is still unbanked or underbanked:

Once you log into MercadoLibre marketplace, you automatically have a Mercado Pago account. This is the power of distribution.

It offers all the services neobanks offer today. You can use it as a checking account, you can apply for a credit card, you can even buy crypto.

MercadoLibre basically wins two times in this system: It cuts commission from the merchant who makes the payment and if the payer also uses a Mercado Pago product, it also earns fees for facilitating the payment.

Mercado Credito is also a genius addition to its ecosystem. It makes merchants two times more dependent on Meli.

Credito lends to both customers and merchants. Potential of consumer lending is all known but I want to concentrate on the effect of merchant lending here.

Meli developed a proprietary algorithm that allows it to estimate the credit worthiness of the merchant by looking at its sales on Meli Marketplace and at his Mercado Pago account activities.

Once the loan is made, however, the merchant becomes two times more dependent on Meli marketplace as its ability to pay relies on its sales on the platform. This is why he puts double the effort in its Meli store, leveling up the quality and sales.

It’s not just interacting with its partners, it’s also making them dependent on itself.

This may sound evil but it’s an amazingly strong business model.

Mercado Shops is another genius move. I bet many people struggle to associate it with Meli’s marketplace centric business.

Indeed it's counterintuitive.

After all, if you are operating a marketplace, you want individual online stores to fail by themselves so they will end up on your platform.

Sounds like a good strategy, right? No.

Meli thinks better and does better.

It figured out that those who run their own online stores are the ones most reluctant to join in a marketplace.

At this point, many marketplaces make the obvious choice: Accept them as a competitor and wish them fail.

This is a zero sum strategy. You are excluding all the opportunities associated with this segment of the market. Instead of doing that, Meli wanted to capture some of it.

It said “Do you want to use your own individual store? Fine. Here, I am providing you with the infrastructure, fulfillment and payment solutions you will need.” Thus it generates additional revenue by:

• Charging for infrastructure subscription.

• Charging for logistics services.

• Facilitating payments.

Instead of 0, it generates some revenue from that segment. Also, by establishing a partner relationship early on, it ensures that those stores will likely end up on Meli Marketplace if they fail individually.

This is a genius strategy and messages me the business acumen of the management.

Now on top of all these, add the MercadoLibre Classifieds service, which is not a great revenue generator but it’s a great driver of traffic to other Meli services, especially the marketplace.

Now answer these questions:

• How long and how much would it take for a competitor to create a distribution center network comparable to that of Meli?

• How long and how much would it take to create a financial services ecosystem?

• How long would it take to reach a scale where you can lend to your partners?

• How could any competitor convince merchants and users that are indebted to MercadoLibre and whose ability to pay also depends on Meli marketplace, to leave that marketplace and start a new risky journey?

It can’t be done. It already reached a critical mass for both merchants and users and its ecosystem also locked them in.

This is one of the highest quality moats I have ever seen.

Giant, giant MOAT.

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📝Investment Thesis

After setting out how strong the company’s moat actually is, investment thesis becomes self-explanatory to some degree:

• Total addressable market is huge.

Latin America is a huge market for literally every business.

The Continent has a population of 665 million and this is a great opportunity for businesses as it has been an underdeveloped region so far but it’s not going to stay that way.

LatAm, as a region, is expected to grow above 3% annually in the next decade. This means that millions of people will get out of poverty, infrastructure will be cultivated and people will simply have more money to spend on discretionary items.

Total e-commerce volume in LatAm is expected to reach $920 billion by 2026.

Even if we assume that the market will grow only 5% annually post 2026 until 2034, we will have a $1.3 trillion market.

This is a huge TAM for e-commerce.

It doesn’t end here. Fintech is also a great market opportunity for Mercado Libre. As it operates in all segments of Fintech including lending, it’s not wrong to count the total fintech market as TAM. As this market is expected to reach $120 billion by 2034, it is also a great opportunity for Meli.

• Meli’s moat is one of the strongest I have ever seen.

Meli’s ecosystem, as explained above, protects it against current and potential competitors.

When it comes to e-commerce in LatAm, I believe we are looking at a tipped market. It’s nearly impossible for any competitor to enter the market, build an infrastructure and network that could match that of Meli.

Even beyond whether it’s doable, it’s not economically viable. Making all those expenses in e-commerce relies on the assumption that you will sacrifice current profitability for growth and you will recoup your losses when the market tips. If two companies do the same and reach the same scale and capabilities, the market won’t tip and both won't be able to recoup losses. It’s a loser's game. Nobody will try that.

• Meli is the ultimate disrupter.

It obviously has the opportunity to follow Jeff Bezos’ “ultimate disruptor” playbook.

Take logistics for example. The market is expected to reach $1 trillion by 2034.

Meli will have more than three dozen distribution centers by then, its airplane fleet size could also easily double.

It can easily scale this operation to serve non-Meli customers, including merchants and people shipping everyday items.

It can easily own at least 10% of the market, driving another $100 billion in sales.

There are numerous market opportunities like this one and once you have the distribution and capabilities like Meli, you can easily enter these markets and grow into a significant competitor.

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📊Fundamental Analysis

➡️ Business Performance

I live in Florence, Italy. This was the Capital of Renaissance and everyday I look at the architecture, random items of art on the streets with great admiration.

This is exactly the way I am looking at Meli's business performance, it’s a state of art.

It literally grew revenues 8x since 2019 and took net income from -$180 million to $1.4 billion.

You know what it means when a company becomes net earnings positive and keeps the revenue growth rate high as Meli? It starts printing cash.

We are looking at a company whose free cash flow is set to explode in the coming years. Again from Amazon playbook.

What can you say to this performance? If you comment on the performance, it’s just repugnant even if you say it’s “very good”. It's self explanatory.

We should just derive two conclusions:

• It’s about to print cash.

• Exceptional performance will sustain due to the competitive advantages we talked about above.

➡️ Financial Position

It’s a bit more nuanced but not that much.

If you followed Amazon for years like me, when you look at Meli's balance sheet you also instantly say that it’s again Amazon playbook.

It’s heavily investing in growth and financing investments largely by debt as it’s cheaper than equity.

This makes sense if:

• You have access to equity investment if need arises.

• You have immense earning power.

Meli has immense earnings power so it has legroom to use leverage in its operations.

Given that equity base only becomes relevant in case the company is headed for bankruptcy, the real measure of financial health is of course the business’ earning power and its ability to service its debt by its earnings.

Meli’s EBITDA can pay all the debt on the balance sheet within 3 years. That’s indeed exceptional.

It’s incredibly strong.

➡️ Profitability & Efficiency

• Gross & Net Margin

Its gross and net margins are also telling the story: Fast growing company past inflection point with a huge moat.

Its gross margin fluctuated over years between 50% and 58% but it’s stable in this range. Given that the company generates most of its revenue through e-commerce, which is a sector receptive to ups and downs in the macro environment, this fluctuation is normal. Thus, stability of the range is a manifestation of its durable competitive advantage.

Net margin is also expanding fast, showing that the company is transitioning to the profitable growth phase. This is where I like the entry most because:

• You have substantially reduced risk.

• The company still has a long runway.

We are looking at a healthy company, with healthy margins and it’s playing the story it had written for years.

• Return on Invested Capital (ROIC)

Again, again and again…

Take this chart below, blur the company name and tell a seasoned investors it’s Amazon, they’ll believe.

Increasing ROIC but doesn’t seem that high? Just like Amazon.

Take a look at Amazon and you will see a similar picture. Why?

Easy. Because most of the investments of these companies are fixed costs that are required to execute the business model.

You build a distribution center, start operating it and you will have an incremental ROIC as it’ll cut your operation costs a bit. But you don’t see the real return on investment immediately because it doesn’t reach the full capacity. Once it reaches the full capacity over years, you get an exploding return.

So, rest assured. We’ll see exceptional returns on investment.

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📈Valuation

Wow! Valuing Meli’s story literally thrilled me!

The reason is simple:

• Meli’s story is too attractive.

• It has an ecosystem to support the story.

• The story can play out on reasonable assumptions.

As you know, I dislike valuations based on pure numbers.

I see people creating complex spreadsheets and share them under the title of “valuation.”

What’s worse is that people who read those get convinced because they look complicated, highly quantitative.

I am telling you: If you don’t have a story you don’t have a valuation. Just as Aswath Damodaran says.

People share models where they forecast 15% 10 year annual revenue growth for a $100 billion company that operates in a $450 billion market…

Where did you get that number? They look at the past.

Past is only an indicator.

You have to come up with the story first, estimate where it goes and make a revenue forecast. Only after then you look at the past performance to estimate whether there is enough proof that the company can achieve that.

So, let me start with the story first!

Amazon has above 50% market share in the US e-commerce.

I expect Latin America to be a much more fragmented market. Still, considering the strength of Meli's network, I assume it can own 30% of the LatAm e-commerce market.

However, given that it still only operates in 18 LatAm countries out of 33, I assume that its entry and expansion will take time and it’ll own only 10% of the overall market in 2034.

Based on the market forecast we discussed in the thesis, this gives us $130 billion revenue.

Given its customer base and merchant network are strong drivers of growth for its fintech operations, I also conservatively assume that it’ll own 10% of the Fintech market. The market is expected to reach $130 billion by 2034, so we can expect $12 billion revenue from this segment.

As other segments are highly interconnected to the marketplace, I won’t consider them separately. They are already included as growth drivers for marketplace and fintech.

This story gives us a $142 billion revenue potential for 2034 which requires 23% annual revenue growth.

Though this is reasonable, I’ll again employ a layered margin of safety approach and assume just 20% average annual revenue growth.

This gives us a $110 billion revenue target for 2034.

Assuming a conservative 15% net margin, we get $16.5 billion net income.

Attaching a conservative earnings multiple of 25, we get a $412 billion company, 4x from today’s valuation.

Given the company’s strength and literally no risk of permanent loss of capital, I buy into this story everyday!

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🏁Conclusion

MercadoLibre has one of the strongest moats I have ever seen.

• Direct and indirect network effects drive exponential growth.

• Ecosystem of complementary products locks in customers.

This is nearly impenetrable.

You may have a superior business model but Meli’s lock-in will prevent customers from quickly switching and Meli will eventually match what you have.

Its total addressable market is also huge, allowing us to write a compelling story. What’s better is that Meli’s past performance messages us that it can execute on the story.

On the valuation front, the market underestimates its potential. This is largely because analysts just run the numbers without creating the story. Wall Street made the same mistake with Amazon over and over again. It always does.

Overall, I think we have all ingredients of a great investment:

• Strong moat.

• Compelling story.

• Attractive valuation.

I think Meli is now one of the few “no-brainer” plays in the market!

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That’s all friends!

Thanks for reading Capitalist-Letters!

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👋🏽👋🏽See you in the next issue!